Friday, April 29, 2011

I have long been of the opinion that the ECB will start to raise rates early (see A higher ECB repo rate by June dated Feb 2) but leave liquidity ample and that this would not constitute a policy mistake (see No ECB policy mistake dated April 5) as the North-Eastern countries need higher rates whereas the ECB repo rate has lost in importance for the fiscally challenged and economically underperforming peripheral countries.The latest economic data - be it real activity, inflation or monetary data - all support the case for further significant rate hikes to 2-2.25% by year end (which means the ECB will likely take a 50bp step, probably in Q4). Today's 2.8% estimate for yoy CPI in April marks the highest inflation rate in the ECB's history, barring the end 2007-end 2008 period when, however, the repo rate stood at 4% (and was raised to 4.25% in the summer 2008) and just before the deflationary impact of the Great Recession depressed inflation rates again. Now the repo rate stands at only 1.25% and given the surging inflation rates has increasingly accommodative effects on the already strongly growing North-Eastern countries, most notably Germany. And to reiterate: For the economically weak peripheral countries the level of the repo rate has lost in importance as bond yields have become much more dependent on credit developments (Spain, Italy, Belgium) or are a matter of negotiations with the EU/IMF (for Greece, Ireland, Portugal). Additionally, for the banking sectors in these countries it remains more important to secure funding than the price they pay for this funding and here the ECB still provides ample liquidity.Furthermore, today's M3 data - where yoy growth came in at 2.3% - only look low at first sight. I have long been of the opinion that looking at M3 does not provide an accurate picture about the state of the economy/future inflation risks. Given that M1 constitutes roughly half of M3, and M1 is extremely influenced by the ECB's balance sheet developments, M3 is very dependent on the ECB's measures as well. When the ECB significantly lengthened its balance sheet in 2008 to support the financial system, it also helped to stabilise M3. However, the related growth in M3 was not a precursor of inflation. Now that the ECB stopped growing its balance sheet, M3 growth is being depressed. In turn, M3 growth remains distorted and does not provide accurate signals about future inflation pressures.

ECB Balance Sheet (in €mln)

Source: Bloomberg

I think that a much better indicator of inflation pressures than M3 growth is growth in M3-M1. M3-M1 is not distorted by the ECB's balance sheets actions and much better reflects supply and demand for funds in the banking sector and the real economy. The chart below shows yoy growth in M3-M1 compared to growth in M3. It highlights that in 2008 inflationary dangers were unprecedented (whereas according to M3 they were similar to late 2001), in 2009 deflationary pressures were larger than M3 data indicated and that by now inflationary pressures are similar to late 2005. Yoy growth in M3 of 2.3% is still the lowest in the history of the Euro, barring the period since the Great Recession. In turn, M3 data would suggest that inflationary pressures remain very low, whereas M3-M1 data shows that inflationary pressures have risen significantly.

M3-M1 does not track M3 all the time

Source: ECB, ResearchAhead

Finally, growth in M3-M1 fits well with headline inflation and has a good fit with the ECB repo rate (in fact a much better fit than M3 data). The chart below compares yoy growth in M3-M1 with the ECB repo rate as well as with yoy headline CPI. As can be seen, growth in M3-M1 tracks the ECB repo rate well, especially since around 2002. It explains why the ECB waited so long in 2005 to hike rates (whereas growth in M3 would have suggested a much earlier rate hike) and again why it chose to hike rates at the start of this month despite low M3 growth data.

Growth in M3-M1 tracks the ECB repo rate well

Source: ECB, Bloomberg, ResearchAhead

Overall, activity, inflation as well as monetary data all suggest the need for a significantly higher ECB repo rate. If history is any guide, the current environment would be compatible with a repo rate of at least 2%! I expect the ECB to take us there by year-end (and to hike further in 2012).

Tuesday, April 5, 2011

Readers of my blog know that I have been expecting the ECB to start hiking rates for quite some time (see for example A higher ECB repo rate by June dated Feb 2). At its last press conference ECB president Trichet strongly hinted at a rate hike for the upcoming meeting this Thursday which caused bank economists' to change their expectations and consensus is now indeed looking for a rate hike this week. However, it frequently is being stated that such a step would be a policy mistake as it would aggravate the economic problems in the periphery and thereby worsens the sovereign debt crisis. For example in the Bloomberg article Trichet risks burying ailing nations with interest-rate rise it stated that "the normalization of rates from a record low of 1 percent will disproportionately hurt Spain, Greece, Portugal and Ireland, while failing to nip inflation threats in Germany." Additionally, a bank economist was quoted with "Greece, where government debt is set to rise to 156 percent of GDP by 2014, will face an additional debt-service charge of 1.6 percent of GDP if market borrowing costs gain 1 percent on the back of the ECB raising rates, Paolini estimates."Now to be sure, I fully agree that the economic environment varies greatly between the north-eastern Eurozone area and the periphery (and will continue to do so for some years) with the periphery needing lower rates than the north-east. However, I am also convinced that given the Eurozone debt crisis, the repo rate has lost in importance for the fiscally weak peripheral countries (or to put it differently: the monetary transmission mechanism in the periphery is impaired). The relationship between the repo rate and peripheral bond yields has weakened dramatically ever since the Eurozone sovereign debt crisis started. The effect of a higher repo rate does therefore not need to translate into higher funding costs which add to cyclical economic weakness. The chart below shows the rolling regression coefficient of changes in 10y bond yields ono changes in the 6x9m EONIA forward rate (over 120 business days). There is a relatively stable relationship between changes in the EONIA forward rate and changes in the 10y Bund yield (with changes in the EONIA forward rate being mirrored almost 1:1 by 10y Bund yields). The R2 value is around 75% (i.e. around 75% of the changes in 10y Bund yields are explained by changes in the EONIA forward rate).

For peripheral bond yields, this is not the case. Since the outbreak of the Greek crisis in spring 2010, the correlation between changes in the EONIA forward rate and 10y Portuguese, Spanish and Italian yields moved into negative territory (i.e. higher peripheral yields went hand in hand with a lower EONIA rate and vice versa). However, regression coefficients have statistically not been different from zero and R2 values have been below 1%. Hence, statistically, peripheral bond yields are currently not dependent on changes in the EONIA forward rate (and with that on ECB rate action). This assessment is being confirmed by the developments over the past weeks. While 10y Bund yields rose by approx. 20bp since the last ECB meeting at the beginning of March (when the ECB prepared the market for a rate hike), 10y BTP and 10y Bono yields are slightly lower by around 5bp. On the other side, Portuguese yields rose sharply amid the political crisis and expectations that Portugal will have to apply for a bail-out soon. Hence, fundamental credit developments seem to be the main driver of peripheral bond yields and not the ECB repo rate!With respect to the Irish and Greek sovereign, the ECB repo rate is even of much less importance. The bond market currently remains shut for these two countries (with Greece only performing some bill issuance) and they fund themselves via the IMF/EU/EFSF at pre-defined interest rates. Changes in the ECB repo rate have no meaningful effect on the interest expense of these countries. In fact, Greece could recently negotiate a reduction in the interest rate it gets charged on the bail-out loans and Ireland tries to achieve the same. For these two countries, the interest rate they have to pay are therefore a function of politics and not of the ECB repo rate.For Eurozone banks, a repo rate rise will mean a higher funding cost. While the strong banks can easily withstand a higher funding cost, for the weak Eurozone banks the most important issue is to get access to enough liquidity with the price being is of secondary importance. And here the ECB seems willing to keep liquidity provision ample. As long as this remains the case, the effects on the banks should be low.For households, credit on new loans will become more expensive but that is wanted for households in the north-east. For households in the periphery, the volume of new loans has been low anyhow and as a result the slowing effect via this channel should prove fairly limited. The larger problem might be that a significant amount of outstanding mortgage loans in Ireland, Spain and Portugal are variable rate loans (linked to Euribor). Given the rise in Euribor rates, this will at the margin negatively affect consumption.

Overall, given that Ireland and Greece currently do not fund themselves in the bond markets and credit fundamentals are more important for the bond yields of the other peripheral countries than the level of the repo rate whereas for the weak banks it is more important that they continue to have access to enough liquidity than the price they pay for this liquidity, the effects of a higher repo rate on the economically weak peripheral countries should be very limited. Only households relying on variable rate mortgages will see a drop in their real spending power. For the north-eastern Eurozone countries the effects of a higher ECB repo rate should have more direct consequences (albeit the level of rates remains very accommodative) given that here the monetary transmission mechanism is working much better. Overall, I previously stated that fundamentally a higher repo rate is warranted (amid the level of real growth, inflation but also given improving monetary developments) and I do not see strong reasons why it should constitute a policy mistake.

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About Me

Daniel was Head of Economics & Strategy for developed markets at Dresdner Kleinwort until early 2009 and was responsible for the well-known 'Ahead of the Curve' flagship publication. He started as a Desk Analyst in the mid-90s for the former German government bond trading desk. He then became Head of Rates Strategy early last decade and later on also took responsibility for G10 economics, commodities strategy and asset allocation.
He is now the owner of Research Ahead GmbH located in Frankfurt am Main.

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